Activism Mergers * Nicole M. Boyson, Nickolay Gantchev, and Anil Shivdasani. October 31, 2016 ABSTRACT

Transcription

1 Activism Mergers * Nicole M. Boyson, Nickolay Gantchev, and Anil Shivdasani October 31, 2016 ABSTRACT Shareholder value creation from hedge fund activism occurs primarily by influencing takeover outcomes for targeted firms. Controlling for selection decisions, activist interventions substantially increase the probability of a takeover offer. Third-party bids for activist targets have higher returns, premia, and completion rates but these patterns are reversed when the activist is the bidder. Failed bids for activism targets lead to improvements in operating performance, financial policy, and positive long-term abnormal returns, suggesting a value-enhancing role of activism. The positive long-term performance from hedge fund activism arises from monitoring target management during M&A contests rather than target undervaluation or bidder overpayment. Keywords: Hedge fund activism, Shareholder activism, Corporate governance, Mergers and acquisitions, Institutional investors JEL classification: G14, G23, G34 *We are grateful to Vyacheslav Fos, April Klein, Doron Levit, Frank Partnoy, Randall Thomas, Margarita Tsoutsoura and Aazam Virani for their helpful comments. We also thank conference and seminar participants at the 2015 Conference on Future Directions in Hedge Fund Activism at the University of San Diego, the 2015 Ackerman Conference on Corporate Governance at Bar-Ilan University, the 2016 UBC Winter Finance Conference, Indiana University, Northeastern University, Temple University, Virginia Tech, University of Arizona, and University of Toronto. Boyson (n.boyson@neu.edu) is from the D Amore-McKim School of Business, Northeastern University. Gantchev (gantchev@unc.edu) and Shivdasani (anil.shivdasani@unc.edu) are from the University of North Carolina s Kenan-Flagler Business School. Send correspondence to Anil Shivdasani, UNC Chapel Hill, CB 3490, 4206 McColl Building, Chapel Hill NC ; Phone: ; Fax

2 1. Introduction In their survey of shareholder activism, Gillan and Starks (2007) define activists as investors, who dissatisfied with some aspect of a company s management or operations, try to bring about change within the company without a change in control [emphasis added]. Although several recent papers show that hedge fund activism improves the performance of targeted firms (Brav, Jiang, Partnoy, and Thomas, 2008; Becht, Franks, Mayer, and Rossi, 2008; Brav, Jiang, and Kim, 2015), there is limited evidence on the precise mechanism through which hedge fund activists enhance shareholder value. We focus on the role of hedge fund activism in corporate control transactions. Although shareholder activism and corporate takeovers have historically been viewed as mutually exclusive channels for disciplining management, activist involvement in takeover situations has become increasingly common in recent years. Further, Greenwood and Schor (2009) find that shareholder activism leads to positive long-term returns for targeted firms only when they are subsequently acquired and that there is no shareholder value creation when they are not acquired following an activist campaign. The finding that positive long-term returns are only observed for activist targets that are subsequently acquired raises several questions. First, does activism create value or arise endogenously when value is likely to be created as a result of a takeover? As shown by Jiang, Li, and Mei (2015), hedge funds often engage in activist risk arbitrage, initiating campaigns after an acquisition has already been announced. Therefore, activist risk arbitrage creates a positive association between takeover activity and activism, making it unclear whether activism targets are more likely to be involved in M&A contests outside of risk arbitrage activity. Second, even if the association between activism and takeovers is not explained by risk arbitrage, do activists actually increase the probability of an acquisition? Or are activist hedge funds simply good at selecting potential takeover targets or investing in advance of merger waves? Third, if activists do influence corporate control events, what is the precise channel through which they create value during M&A contests? Do activists make it more likely that a firm receives an offer, or do they increase the offer price, reduce managerial resistance, or increase the likelihood of merger 1

3 completion? Finally, given recent evidence that target firm returns in corporate takeovers contain a sizeable revaluation component, can the returns following activism be attributed to value creation by hedge fund activists or do they simply reflect the revaluation of undervalued firms? If the returns to takeovers involving shareholder activism are driven by revaluation rather than changes in operational or financial policies, then the stock returns around activist campaigns will overstate the value created by shareholder activists. We explore these questions in this paper. We begin with a comprehensive hand-collected sample of 2,096 activism campaigns over and a merger sample of 3,216 transactions over We first confirm the strong association between activism and takeovers documented by Greenwood and Schor (2009). Over one-third of firms targeted by hedge fund activists during are involved in a takeover bid before or within two years of activist involvement, a proportion that has risen in recent years. However, in almost 30% of these cases, activist involvement is due to risk arbitrage and occurs after the takeover bid, and thus does not cause takeover activity. To isolate campaigns where the activist has the potential to influence the probability of a takeover bid, we exclude cases of activist risk arbitrage 1 and focus on the remaining instances where a merger bid is announced within 2 years of a hedge fund initiating an activist campaign transactions that we call activism mergers. After eliminating 192 cases of activist risk arbitrage, the probability of an activism merger is 22%, about four times larger than the takeover probability when no activist is present. Further, the probability of an activism merger has increased over time, from 20% over to 25% after Thus, rather than being two distinct means of shareholder intervention as sometimes discussed in the theoretical literature (e.g., Maug, 1998), activism and takeovers are closely interrelated. Indeed, our estimates indicate a much stronger link between hedge fund activism and takeovers than that documented by Greenwood and Schor (2009), illustrating the increasing role of shareholder activism in takeovers in recent years. Although we control for a host of firm attributes, we recognize that a potential omitted variable may underlie the relationship between hedge fund activism and merger activity. Are activists simply good at picking firms that are attractive merger targets, or do they also facilitate 1 See Jiang et al. (2015) for a study of activist merger arbitrage. 2

4 the M&A process through their post-intervention activities? To test these alternatives, we control for the selection decisions of activist hedge funds. Specifically, we examine whether targets of hedge fund activism are more likely to receive takeover bids than firms in which the same hedge fund activist owns a purely passive stake. We find a six-to-eight times higher takeover likelihood in activism targets relative to firms in which the same hedge fund is a passive equity holder. To further differentiate between an activist hedge fund s skill to pick stocks with high ex-ante takeover probability from its ability to foster M&A activity through intervention, we exploit the hedge fund s decision to change its legal filing status from Schedule 13G to Schedule 13D, indicating a switch from passive to activist investing in the same firm. 2 We document a three-fold increase in takeover probability in firms with 13G-to-13D switchers relative to firms in which no switch is observed. This finding suggests that the switch to an activist posture leads to a higher probability of a merger. We recognize the possibility that an unobserved time varying factor may be responsible for both the switch to an activist posture and a higher takeover likelihood, although we uncover no evidence in favor of such a factor. These results raise the question of why hedge fund activism is associated with higher acquisition likelihood. As large shareholders, activists may overcome the free-rider problem in corporate takeovers at diffusely held firms (Shleifer and Vishny, 1986). Corum and Levit (2015) also suggest that activist hedge funds help overcome informational frictions faced by target shareholders when evaluating a takeover bid from a third-party. In their model, the endorsement of a third-party bid by an activist hedge fund represents a credible signal that the bid is fair because activists are informed investors that, due to their ownership of the target s shares, face common incentives with other target shareholders. We test this proposition by exploiting variation in bidder identities in our sample of activism mergers. Specifically, over 15% of acquisition bids are launched by the hedge fund activists themselves. Since the activist is both a target shareholder and the bidder in these cases, activist bidders cannot credibly certify the fairness of a takeover proposal. Consistent with this view, we document sharp differences in merger terms and outcomes in activism mergers involving third- 2 Both types of filings are triggered when an investor crosses the 5% ownership threshold but the 13G filing is intended for purely passive investment and imposes less stringent filing requirements. 3

5 party bidders and activist bidders. Activism mergers with third-party bidders experience cumulative abnormal returns (CARs) that are 8% higher than those obtained in non-activism mergers, while offers by activist hedge funds result in 18% lower CARs relative to those in nonactivism mergers. Activist bidders offer lower acquisition premiums and experience far higher rejection rates than third-party bidders. Although activist bidders frequently attract follow-on bidders, overall merger completion rates are still significantly lower than those for targets not involving activist bidders. These results are consistent with the view that separation of the activist and bidder functions is critical for activists to enhance value during corporate takeovers. If separation of the activist and bidder functions is critical, why do activists sometimes become bidders even though their takeover attempts are often unsuccessful? We explore three explanations for the prevalence of activist bidders. We examine whether activists primarily launch low-ball offers in an attempt to put firms in play without the intention to acquire control but find that this is not the predominant explanation. We also explore whether activists launch bids for undervalued firms in an attempt to benefit from a takeover-induced revaluation of the firm. As shown by Malmendier, Opp, and Saidi (2016), merger announcement returns consist of two distinct effects a revaluation effect that is independent of the expected merger benefits, and an operational effect, which captures expected synergies and operational improvements. Applying their framework to our sample of failed mergers, we find that almost all of the merger announcement return in activism mergers is reversed upon deal failure; that is, returns in failed activism mergers are not driven by a revaluation of the targets standalone value. Our evidence favors a third explanation whereby a takeover bid, even when unsuccessful, is associated with value-enhancing operational and financial policy changes at activist targets. Consistent with this view, we find that activist targets that receive unsuccessful acquisition bids experience greater improvements in operating performance and changes in investment policy, leverage, and payout, relative to activist targets that are not involved in takeover contests. Further, activist targets that remain independent following an acquisition bid display significantly positive long-term abnormal returns that are correlated with changes in operational performance and 4

6 financial policies. Hence, these operational and financial improvements help explain the positive long-term returns to shareholder activism even when an acquisition attempt is not consummated. Finally, we examine Greenwood and Schor (2009) s conjecture that the high incidence of takeover offers and the positive returns associated with activism may be due to the activists picking firms for which potential acquirers might overpay. According to this explanation, bidder returns should be lower in activism mergers. Alternatively, if an activist campaign lowers managerial resistance and increases target management s receptivity to an offer, bidders may be less likely to overpay for acquisitions involving activist targets. Indeed, we find weak evidence that bidder announcement returns are higher in activism mergers than in non-activism mergers, a finding that is inconsistent with the overpayment hypothesis. Our findings contribute to the growing literature on hedge fund activism by relating the documented positive returns in activism (see Brav et al., 2008; Clifford, 2008; Klein and Zur, 2009; Boyson and Mooradian, 2011) to merger activity and highlighting the key role of the takeover market in enabling value creation from shareholder activism. We confirm the link between activism and takeover activity shown by Greenwood and Schor (2009) but also present evidence suggesting a treatment effect rather than a pure selection effect. Further, we illustrate specific mechanisms through which activist investors facilitate the market for corporate control; activists appear to certify the fairness of a third-party offer and increase target management s receptivity to a merger. Our results illuminate a multi-faceted role of activists that extends beyond the promotion of acquisition likelihood as a means of value creation - activist involvement entails higher announcement returns, acquisition premiums and completion probabilities, but only when the acquirer is not the hedge fund activist. In addition, even when a merger offer is unsuccessful, the offer is associated with an increase in the valuation of the target firm through the implementation of real financial and investment policy changes rather than through revaluation effects. More broadly, our paper builds on the theoretical literature studying the role of large shareholders in the merger process. Shleifer and Vishny (1986) argue that large shareholders help overcome a free-rider problem among diffuse shareholders, and thereby facilitate third-party 5

7 takeovers. Maug (1998) considers monitoring and takeovers as two different forms by which a large outside investor can intervene and shows that market liquidity determines the trade-off between the costs and benefits of the two approaches. Burkart and Lee (2015) integrate activism and takeovers in a unified model framework but consider them as polar approaches to the dual free-rider problem. Our results suggest that instead of being two distinct ways of monitoring to overcome informational frictions, shareholder activism and takeovers are closely related mechanisms that help promote the functioning of the market for corporate control. Our evidence highlights the critical nature of the interaction between activism and mergers since we find no evidence of long-term value creation associated with activism in the absence of M&A activity. Our findings also contribute to the broader literature on hedge funds, particularly as it relates to the returns from event-driven strategies, including distressed and vulture investing. Jiang, Li, and Wang (2012) show that hedge funds play an important role during Chapter 11 reorganizations by balancing the power between the firm and its secured creditors and overcoming creditor conflicts that arise during financial distress (Gertner and Scharfstein, 1991). Lim (2015) finds that activist hedge funds alleviate contracting frictions during financial distress and facilitate creditor renegotiations, while Lewis (2016) shows that vulture hedge funds enable higher bondholder recovery rates during financial distress. Similar to these papers, we find a value-enhancing role performed by activist hedge funds in the context of corporate mergers, even though the characteristics of firms engaging in mergers and the frictions that arise during the merger process are very different from those in financial distress. 2. Role of activists in M&A activity There is substantial evidence that hedge fund activism is associated with positive returns around the initiation of an activist campaign. Brav, Jiang, and Kim (2010) document an average return of 5% over the (-20, +20) day window around the announcement of activism. 3 Over the next 36 months, they do not find evidence of return reversal, suggesting that the abnormal returns 3 Other studies document similar short-term returns. Clifford (2008) estimates a (-2, +2) day market-adjusted return of 3.4%; Klein and Zur (2009) find a (-30, +30) day market-adjusted return of 7.2%; Greenwood and Schor (2009) show an average (-10, +5) day abnormal return of 3.6%; Boyson and Mooradian (2011) find a (- 25, +25) day cumulative abnormal return of 8.1%. 6

8 are not due to buying pressure or market over-reaction. Over a (0, +36) month interval, Clifford (2008) documents three- and four-factor alphas of % and Greenwood and Schor (2009) find (-1, +18) month three-factor CARs of 10.26%. Gantchev (2013) shows that these positive abnormal returns persist even after netting out the costs of activist intervention. Bebchuk, Brav, and Jiang (2015) report positive and statistically significant four-factor alphas over the five-year period following the activist campaign. There is, however, ongoing debate about the sources of value creation from shareholder activism. Brav, Jiang, and Kim (2010) find the highest abnormal returns in campaigns demanding a sale of the company or changes in business strategy but statistically insignificant returns in campaigns targeting capital structure and governance. In contrast, Boyson and Mooradian (2011) show that governance-related activism generates positive short- and long-term performance. Greenwood and Schor (2009) argue that value creation in activism comes only when targeted firms are successfully acquired post-activism. They document a statistically significant (-1, +18 month) three-factor CAR of 26% in the sample of activism targets that get acquired but an insignificant 3% CAR for the sample of targets that are not acquired. The finding that the long-term returns to shareholder activism are only observed for firms that are eventually acquired raises several important questions about whether and how shareholder activism creates value. Perhaps the most salient of these questions is whether there is any evidence of a causal effect of activism on merger activity. As we discuss below, activist targets may appear to have a higher likelihood of being acquired because hedge funds often launch activism campaigns after a firm has received an acquisition proposal (Jiang et al., 2015). If this behavior drives the relationship between activism and M&A activity, the returns following activism will overstate the value creation by hedge fund activists. Similarly, it is also possible that activists are simply good at picking firms that are already more likely to be acquired or that they tend to launch campaigns during merger waves. If hedge fund activists are adept at predicting takeover targets, the positive returns following activism will reflect their stockselection abilities rather than any value creation role. 7

9 Alternatively, shareholder activism can have a causal effect on M&A activity by lowering frictions in the market for corporate control. In Shleifer and Vishny (1986), a large shareholder helps overcome a free-rider problem among diffuse shareholders and increases the likelihood of a takeover. In their model, gaining control of the firm allows the large shareholder to raise the value of his existing stake in a more effective manner than alternative channels such as proxy contests. Similar arguments are also developed by Hirshleifer and Titman (1990) and Maug (1998). While these arguments explain why activist investors can promote mergers, Corum and Levit (2015) propose that activists serve an additional role that cannot be performed by outside bidders. In their model, bidders can use a proxy contest to overcome managerial resistance to an offer. However, they face a commitment problem as they are prone to extracting private benefits and making low-ball offers if they gain control of the target s board. Activists do not face this credibility problem because of their status as shareholders of the target firm; they do not stand to gain from a low-valued offer. Hence, activists can use the threat of a proxy contest to lower management resistance and increase the likelihood of an outside offer in a manner that cannot be replicated by outside bidders. An alternative channel through which activist investors might influence the likelihood of an acquisition is by inducing bidder overpayment. Greenwood and Schor (2009) suggest that bidders may overpay when an activist is present, which makes the target more receptive to an acquisition and increases the probability that a transaction is consummated. Although Greenwood and Schor (2009) do not specify why bidders might be prone to overpayment in activism mergers, under this channel, the positive returns to activist targets come partly at the expense of bidder shareholders, and hence overstate the overall economic benefits from shareholder activism. In addition to affecting the likelihood of an acquisition, hedge fund activism also has the potential to influence the terms of the merger by lowering agency costs during takeovers. Wulf (2004) shows that target managers face self-dealing incentives during mergers and negotiate favorable post-merger control terms in exchange for lower acquisition premiums. Hartzell, Ofek, and Yermack (2004) find that target managers sometimes negotiate extraordinary personal 8

10 benefits in M&A transactions, resulting in lower premia for shareholders. Similarly, Fich, Rice, and Tran (2016) find that managers in high agency cost firms negotiate merger payments that come at the expense of higher acquisition premia for their shareholders. The threat of a proxy contest by an activist hedge fund can serve as a monitoring mechanism that mitigates such potential self-dealing, allowing a bidder to share more of the expected takeover gains with target shareholders instead of target management. Under this view, acquisition premia for targets of shareholder activism are higher than when an activist is not present, all else equal. 3. Institutional background and data 3.1. Reporting requirements for beneficial owners Any investor or group acquiring more than 5% of the voting stock of a public firm is required to file a beneficial ownership report Schedule 13D or 13G with the US Securities and Exchange Commission (SEC). Under the 1934 Securities Exchange Act, a Schedule 13D filing has to occur within ten days of crossing the reporting threshold. Schedule 13D requires disclosure of the identity and background of the owner, the source and amount of funds, the purpose of the investment, contracts and arrangements with respect to the securities of the issuer, and communications with the issuer. In addition, the SEC considers changes in ownership of 1% or more to be material, requiring the investor to file an amendment to Schedule 13D. To ease disclosure requirements, passive investors are permitted a shorter 13G filing. To be eligible for a 13G filing, the investor must not have acquired the securities with any purpose, or with the effect of, changing or influencing the control of the issuer, or in connection with or as a participant in any transaction having that purpose or effect. Passive investors are required to file an amendment within 45 days of the end of the calendar year if there are any changes in their ownership and amend the filing promptly if the ownership exceeds 10%. 13G investors lose their passive status upon acquiring or holding securities with the intent to change or influence control of the issuer or when their ownership exceeds 20% and must switch to a 13D filing within 10 days. Further, they are prohibited from voting or acquiring additional securities for 10 days after the 13D filing is made. 9

11 Ownership reporting violations under the Exchange Act are subject to prosecution and penalties and the SEC is not required to prove knowledge, recklessness, or negligence on the part of the investor. Further, Edmans, Fang, and Zur (2013) and Brav, Jiang, and Kim (2015) argue that passive investors are unlikely to opt for a 13D filing instead of a 13G filing for several reasons. First, the mandated frequent amendments triggered by ownership changes of 1% or more limit the investor s ability to trade since the disclosure tends to move prices against the investor. Second, a Schedule 13D is often accompanied by a confrontational attitude from the firm s management and directors, which can impede the investor s ability to acquire firm-specific information. Third, a Schedule 13D filing is sometimes followed by negative events, such as credit rating reviews or downgrades, which can hurt the investor s position in the stock. Thus, investors have incentives to file their ownership report in an accurate and timely manner and therefore their status as a 13D or 13G filer is commonly used to identify their stance as an activist or passive investor (e.g. Edmans et al., 2013, Brav et al., 2015) Sample construction and summary statistics Our sample of hedge fund activism and merger activity comes from two primary sources hand-collected data on hedge fund activism campaigns over and merger data from Thomson Reuters SDC Platinum (SDC) over We construct the initial sample of hedge fund activism campaigns using the SharkRepellent database. The primary source for these campaigns is Schedule 13D filings. A secondary source for the activism events in the SharkRepellent database is proxy contests initiated by hedge funds (PREC and DEFC forms) in which the activists ownership may not reach the 5% reporting threshold. Since SharkRepellent does not capture all 13D filings, we augment the sample with hand-collected 13D reports. We confirm the identity of the activist investors as hedge funds using SEC registration statements (ADV filings) along with web and media searches. To ensure that our sample includes only hedge funds with an activist agenda, we define an Activist as a hedge fund that has accumulated an activist block of 5% in more than one target (reported in a 13D filing) or initiated at least one proxy contest (measured by a PREC or DEFC report) over For each of 10

12 the 532 activist hedge funds that we identify in our sample, we obtain all Schedule 13D (13D/A) and proxy filings over the sample period. The mean and median number of 13D filings (i.e., unique campaigns) for our sample of activists is 9 and 5, respectively. We match activism targets to merger data from SDC, manually verifying the quality of each match. We include all merger bids regardless of whether they result in a completed transaction. We adopt the usual filters from prior literature and include all mergers of U.S. public firms with a deal size of at least $10 million. We also require that the bidder owns less than 50% of the target s stock before the bid and exclude divestitures, spin-offs, and share repurchases. We manually verify the announcement, completion, and withdrawal dates reported in SDC to ensure that our return calculations are over the correct intervals. We combine the merger and activism datasets with the universe of CRSP-Compustat firms to create an annual firm-year panel. We group multiple hedge fund campaigns within the same firm-year as a single activism observation, considering the hedge fund that intervenes first as the primary activist. The full panel consists of 62,066 firm-years, including 3,216 firm-years with a merger bid, and 2,096 firm-years with a hedge fund activism campaign. Column (1) of Table 1 shows that the number of activism campaigns peaks in and column (2) shows that the frequency of hedge fund activism has grown from 2.7% over the first half of our sample to 4.9% in the post-2007 period. In contrast to activism, the frequency of takeover bids peaks in 2000 and is generally higher in the early part of the sample period (5.6% in vs. 5.1% post-2007). As reported in Column (5), there are 192 activism events over our sample period in which the activist initiates a campaign after the merger announcement but before its completion. We consider these campaigns as cases of activist risk arbitrage and exclude them from our activism merger sample. These activism events are the subject of a contemporaneous paper by Jiang et al. (2015) who show that activist risk arbitrage helps protect the interests of shareholders during corporate control contests. For each activism campaign, we track subsequent merger activity and require that a merger bid be announced within 2 years of the initiation of the activism campaign. We also manually 11

13 verify that the activist is still present at the time of the merger announcement. As reported in column (7), our sample includes 467 activism targets that receive subsequent merger bids, representing a 22% frequency of a merger bid for these firms. Henceforth, we refer to these bids as activism mergers. To understand whether hedge fund activists are simply adept at predicting likely merger targets, we study the sample of firms that receive takeover offers. We divide this sample into two groups merger targets that are also targets of hedge fund activism (467 firms) and merger targets that are not targets of hedge fund activism (2,749 firms). All variables except dummies are winsorized at the 1% and 99% levels. Table 2 shows that merger targets with and without activist involvement share several attributes on average, they are smaller firms and have lower dividend yields than firms in CRSP-Compustat. Activism and merger targets also display similar leverage and R&D expenditures as those of CRSP-Compustat firms. However, merger targets with activist involvement differ from those without such involvement on several dimensions targets with activist involvement have higher institutional ownership, lower standard deviation of daily stock returns, better liquidity, and lower market-to-book ratios. Prior literature demonstrates that these characteristics are predictive of activism; e.g., higher institutional ownership positively affects the outcome of a campaign in its more confrontational stages (Brav et al., 2010) whereas liquidity lowers the costs of entering and exiting an activist position (Edmans et al., 2013). 4. Probability of receiving a takeover bid We begin by examining whether hedge fund activism is associated with a higher probability that a firm is subsequently involved in an M&A transaction. To avoid activism that arises endogenously as a result of a takeover bid, we exclude activist campaigns that are initiated after the announcement of an M&A offer. Our sample for these tests includes 3,216 takeover bids and 1,904 activism campaigns over 62,066 firm-years. Table 3 presents estimates from logistic models of the probability that a firm receives a takeover bid in a given firm-year. The key independent variable, Activist, is an indicator set to one if a hedge fund activist initiated a campaign against the target firm in the two calendar years 12

14 prior to the merger proposal, and zero otherwise. All regressions include year and industry fixed effects. Standard errors are clustered by year and firm. We include a number of variables to control for firm characteristics that may affect the probability that a firm becomes a takeover target. As reported in Table 2, activism targets have lower market capitalization and market-to-book ratio in comparison to both the average firm in CRSP-Compustat and to merger targets. In addition, activism targets have better stock liquidity (i.e., lower illiquidity as measured by the Amihud ratio) and lower standard deviation of daily stock returns. According to prior literature, these characteristics are correlated with the probability of receiving a takeover offer (e.g., see Moeller, Schlingemann, and Stulz 2005; Bargeron, Schlingemann, Stulz, and Zutter, 2008; and Bauguess, Moeller, Schlingemann, and Zutter, 2009). As additional control variables, we include institutional ownership, return on assets, leverage, dividend yield, and R&D expenditures. To account for the possibility that activists time their interventions to coincide with periods of heightened merger activity in the target firm s industry, we also control for whether an industry experiences a merger wave in a given year. Following the approach in Harford (2005), we create an indicator, Merger Wave, set to one if the number of mergers in an industry during any consecutive two-year period is greater than the 95 th percentile of a uniform distribution over the entire sample period. Each industry is restricted to two waves over the full period. We include both Merger Wave and its interaction with Activist to examine whether hedge fund activism has a differential effect on the likelihood of an M&A offer during industry merger waves. Column (1) of Table 3 shows that Activist has a positive and statistically significant association with the probability of receiving a takeover offer. In economic terms, Activist increases the probability of a takeover bid to 22.9%, almost five times higher than the unconditional probability of 4.6%. Greenwood and Schor (2009), whose sample ends in 2006, report that activism targets experience a 2.5 times higher probability of being acquired compared to firms matched on industry, size, and past stock returns. Despite excluding risk arbitrage activity, we find a much stronger association between activism and M&A activity than they document, due in part to the growing frequency of post-activism M&A after

15 Column (2) considers the probability of an offer from a third-party bidder, excluding activism events in which the activist is also the bidder. The coefficient on Activist remains positive and statistically significant in this specification. In terms of economic magnitude, Activist increases the probability of a third-party takeover offer to 20.2%, relative to the unconditional probability of 4.6%. To explore whether our results are driven by leveraged buyout (LBO) transactions, columns (3) and (4) of Table 3 separately examine strategic and financial bids. We find that offers by both strategic and financial buyers are significantly more likely following an activism campaign. In economic terms, the documented effect is stronger for financial bids the indicator Activist is associated with a nine-times higher probability of a financial offer (an increase from 0.5% to 4.4% as seen in column (4)) and a four-times higher probability of a strategic offer (an increase from 3.8% to 14.8% in column (3)). The interaction between Activist and Merger Wave is not statistically significant in any of the specifications, suggesting that firms are not more prone to receiving takeover bids if the activism campaign is initiated during a merger wave. The other control variables have the expected signs. Institutional ownership and liquidity have a positive correlation with the probability of receiving a takeover bid whereas standard deviation of daily stock returns, Tobin s Q, market capitalization, and dividend yield exhibit a negative correlation. What explains the positive relationship between hedge fund activism and the incidence of subsequent takeovers? Are activist hedge funds simply good at picking firms that are attractive merger targets a selection effect arising due to potentially unobserved variables or is there a treatment effect of activism on M&A activity? To address this identification issue, we investigate whether activist ownership has a differential effect on the probability of a takeover bid relative to passive ownership by the same activist hedge fund. To do so, we manually match our sample of activists to holdings data from the Thomson Reuters 13F database. 4 About two-thirds of the 532 activist hedge funds over have available 13F data. As an example, Carl Icahn reports ownership in 90 different companies over , of which 38 have been accompanied by an 4 The SEC requires that institutional investors with over $100 million in assets under management file quarterly holdings reports, known as 13F filings. 14

16 announcement of activist intentions (in a Schedule 13D or a contested proxy solicitation). Our analysis studies whether Carl Icahn s activist agenda in these 38 companies is more likely to lead to a takeover bid relative to the likelihood of a bid for the other 52 firms in which he holds a passive stake. Columns (1)-(4) of Table 4 report estimates of OLS regressions of the probability of receiving a takeover bid for the sample of firms where activist hedge funds disclose either a passive or active stake. The unit of observation is an activist-firm-year. We include the same controls as in Table 3 but add hedge fund fixed effects to control for time-invariant characteristics of activist hedge funds. We define a variable HF active stake, which equals one if the activist hedge fund has declared activist intentions in a given firm, and zero otherwise. The coefficient on HF active stake is positive and statistically significant in column (1). In terms of economic magnitude, HF active stake is associated with a 18.7% higher probability of a takeover bid relative to the probability of a bid in other firms in which the same hedge fund has a passive stake. This represents more than a six-fold increase, given the unconditional takeover probability of 2.9% in this sample (not tabulated). Column (2) includes the continuous variable % held and its interaction with HF active stake. A 1% increase in hedge fund ownership is associated with a 18.8% decrease in the probability of receiving a takeover bid. More importantly, the interaction of % held with HF active stake is positive and significant, suggesting that higher ownership in firms in which the activist hedge fund has declared activist intentions is associated with a substantial increase in the probability of a takeover bid. In columns (3) and (4), we include indicator variables for % held > 1% and % held > 5% instead of the continuous measure of hedge fund ownership. Both interactions with HF active stake are positive and significant. In addition, the economic magnitudes are large; for example, the model in column (4) implies that having a 5% or higher stake in firms in which the activist hedge fund has declared activist intentions is associated with an eight-fold increase in the probability of receiving a takeover bid compared to the probability of a bid in firms in which the same hedge fund has a passive 5% block. In all specifications, the interaction between HF active stake and Merger Wave is statistically insignificant suggesting that these results are not driven by 15

17 activists attempting to time their actions in advance of heightened merger activity. Columns (5)- (8) confirm these findings using a logistic regression, indicating that our results are not sensitive to the model specification. Even though we control for observable firm characteristics and hedge fund fixed effects in Table 4, it is possible that there are unobserved differences between the firms that hedge funds pick for their active and passive investments. For example, hedge funds may choose well managed but undervalued firms for their passive investments, but select poorly managed firms for their active investments because they have a higher probability of being acquired. Therefore, in Table 5, we fix the hedge fund-firm pair and exploit the decision of an activist fund to change the legal filing status of an ownership position from Schedule 13G to Schedule 13D, indicating a switch from passive ownership to activist investing in the same firm. As argued by Brav et al. (2015), this test provides a clean identification of intervention beyond stock picking. Thus, this test allows us to differentiate an activist hedge fund s ability to pick stocks with high ex-ante takeover probability from its ability to foster M&A activity through its intervention. We match our sample of activist hedge funds to data on 13G filings, generously provided to us by Brav, Jiang, Ma, and Tian (2015). Our sample includes 3,159 activist-firm-year observations with 13G filings and 159 switches from Schedule 13G to 13D. We create an indicator variable 13G-to-13D Switcher set to one for firms in which the activist s filing status switches from passive ownership to activist investment. The dependent variable is a dummy set to one if a takeover bid is announced within two years of the initial 13G filing or the 13G-to-13D switch, if any. All regressions include industry and year fixed effects. In addition, columns (3) and (6) also include hedge fund fixed effects. Columns (1)-(3) of Table 5 present estimates of OLS models of takeover probability for the sample of firms with 13G hedge fund filers. The results in column (1) reveal that firms in which the activist switches from 13G to 13D experience a 10.1% higher takeover probability compared to firms in which no switch is observed. This three-fold increase (relative to the unconditional probability of 5.5% in the 13G sample) suggests an incremental effect of the activist intervention above and beyond any stock-picking ability of the hedge fund. Column (2) includes the firm and 16

18 industry controls from Table 2 whereas column (3) adds hedge fund fixed effects to control for time-invariant activist characteristics. The statistical and economic significance of the results remain virtually unchanged. In unreported tests, we include an interaction between 13G to 13D switchers and the Merger Wave indicator and find it to be insignificant. In columns (4)-(6), we confirm these findings using a logistic regression model. Overall, these results indicate that shareholder activism campaigns are associated with a substantial increase in the probability that a firm receives a takeover bid. The effect we document is much larger than previously shown by Greenwood and Schor (2009) despite our exclusion of risk arbitrage activism which represents a sizeable portion of activism around M&A. We find that controlling for time-invariant activist characteristics, activist ownership has a substantially higher effect on the probability of a takeover bid relative to other firms in which the same hedge fund has a passive stake. Further, exploiting the legal requirements for ownership disclosure, we show that an activist s switch from 13G (passive) to 13D (activist) status within the same firm is associated with a substantial increase in that firm s takeover probability. This test controls for unobserved time-invariant differences between an activist s 13G and 13D investments, but does not address potential time-varying unobserved differences. For example, it is possible that following a passive 13G investment, an activist receives a signal that the firm has become a likely takeover target, and decides to shift to an activist posture. While we cannot rule out this possibility, we note that unless a shift to an activist posture facilitates a takeover, there is no clear incentive for the activist hedge fund to switch its filing status. Further, the increase in takeover probability does not depend on whether the activist campaign occurs during a merger wave. To the extent that an activist s incentive to acquire a costly signal is greater during a merger wave, this finding is at odds with such a time-varying signal explanation. Additionally, even if the incidence of mergers is driven by selection effects, it is unclear why such selection effects would influence the terms of the merger transaction, an issue to which we now turn. 5. Role of activists in merger outcomes We now explore how activists influence the merger process. As discussed earlier, activists can help overcome frictions associated with target management entrenchment. Self-interested 17

19 target managers may be motivated by their personal gains rather than shareholder gains in mergers. For example, Hartzell, Ofek, and Yermack (2004) find that when target CEOs receive extra benefits during mergers, acquisition premiums are lower. Activist investors, by threatening to replace management and the board, can lower the likelihood of such self-dealing, allowing potential bidders to offer a higher price for the target. Consistent with such a monitoring role for activists during M&A contests, Jiang et al. (2015) show that activist risk arbitrage is more likely to occur when firms negotiate friendly and low-premium acquisitions. In addition, if activist investors promote M&A likelihood by overcoming managerial resistance, acquisition offers are also more likely to be successfully completed. These arguments suggest that acquisition premia, target shareholder announcement returns, and offer completion rates in M&A transactions should be higher when an activist investor is present. As discussed earlier, an activist s support of a third-party offer may certify to target shareholders than the offer is fairly valued, thereby overcoming managerial resistance. If resistance is costly, this allows the bidder to offer a higher price by lowering the costs of the acquisition, thus increasing the likelihood of completion. The ability of an activist hedge fund to overcome these frictions arises because its incentives are aligned with those of the target shareholders rather than those of the bidder. We test this argument by exploiting the variation in bidder identities in our sample. As discussed earlier, a sizeable proportion of offers are initiated by the activist hedge funds. These activist bidders have incentives to acquire the firm cheaply rather than maximize value for target shareholders. Therefore, we expect that relative to third-party bidders, activist bidders are less able to overcome management resistance and their offers are less likely to succeed due to uncertainty about whether these offers represent a fair price for target shareholders. Since activist bidders have incentives to acquire the firm for a low price, we also expect announcement returns for target firms to be lower for mergers involving activist bidders. Of the 467 activism mergers in our sample, the hedge fund that initiates the campaign is also the bidder in 76 cases. These activist bidders include well-known hedge funds such as Carl Icahn (9 offers), Elliott Associates (7 offers), Newcastle Partners (5 offers), ValueAct (4 offers), and 18

20 Steel Partners (4 offers). In 52 of the 76 cases involving activist bidders, the activist hedge fund is the only bidder, whereas the targets in the remaining 24 cases receive multiple bids. In 46 cases involving hedge fund bidders, the offer to acquire the target occurs simultaneously with the initiation of the activist campaign. 5 We present summary statistics comparing activist bids and third-party bids in Table 6. Panel A of Table 6 compares characteristics of target firms according to whether they receive an activist bid or a bid from a third-party acquirer. Targets of activist bidders have lower average levels of R&D expenditures and higher industry concentration, but are similar to targets of thirdparty bidders with respect to other firm characteristics. Panel B compares target announcement acquisition returns and acquisition premia for activist and third-party bidders. We calculate announcement CARs in excess of the value-weighted CRSP index return over days (-1, +1) around the merger announcement. Announcement CARs are significantly lower for activist bids, averaging 11.6%, compared to 14.6% for third-party bids. To ensure that this difference is not driven by the anticipation of a bid when an activist first discloses a stake in the firm, we also compute CARs over a longer window that includes the initial entry of the activist. Specifically, we compute CARs from 25 days prior to campaign initiation through 5 days after the merger announcement. With this approach, we continue to find that announcement returns are lower for activist bidders, averaging 17.1%, relative to 43.4% for third-party bidders. The lower announcement returns for activist bidders appear to be driven by both lower premiums offered as well as lower completion probabilities. Relative to the target s stock price 25 days prior to merger announcement, the average acquisition premium offered by activist bidders is 32.8%, compared to 55.3% for third party bidders. 6 When we recalculate acquisition premia relative to 25 days before the activism announcement, the mean premium is 40.9% for offers by activist bidders and 77.7% for third party bids, with the difference being statistically 5 In almost all cases involving multiple bidders, the activist hedge fund is the first bidder for the firm. However, in seven cases, the hedge fund activist bid occurs after the target has received a bid from a third party, suggesting that these observations could potentially be classified alternatively as third-party bids. Our results are essentially invariant with respect to this distinction. 6 We use a 25-day interval to determine the unaffected stock price of the target because Schwert (1996) shows that run-ups do not occur prior to 21 days before a merger bid and for comparability of our returns to Malmendier et al. (2016) who also use a 25-day interval. 19